How To Calculate ROI And Why You Need It
ROI stands for ‘Return on Investment’, and it gives an investor the ability to assess and evaluate an investment's performance in comparison to other assets in the portfolio.
Consider two marketing departments of various organizations submitting their budgets for evaluation. If Marketing Department A displays the ROI accurately in its budget, while Marketing Department B pays little to no attention to the ROI, Marketing Department A is more likely to have the higher budgets that they need, than B, which did not include the ROI at all.
The reason for this isn’t farfetched. With a clear view of the ROI, a business or an investor will be able to ascertain exactly what the true money’s gain of any investment is.
ROI stands for ‘Return on Investment’, and it gives an investor the ability to assess and evaluate an investment's performance in comparison to other assets in the portfolio.
ROI is a financial metric generally used to measure the likelihood of profiting from an investment. It compares the gain or loss from an investment in direct relation to the cost of the transaction.
In other words, if you invest in a stock, after a specificied period, you must be able to determine what your returns are especially in relation to the cost you incurred to purchase the stock (amongst other associated costs).
ROI, Net Present Value (NPV) and other cash flow measures are core metrics used in evaluating the profitability of a number of various investments. ROI is generally expressed as a percentage, despite the fact that it is a ratio. Simply put, it is an approximation of an investment's profits.
How to Calculate ROI
Return on Investment is typically easy to calculate and relatively simple to understand, making it a standard measure of an investment’s profitability. There are two basic ways to calculate ROI.
METHOD ONE
The Return on Investment is gotten by dividing the net return of investment by the cost of the cost of investment. The result is then multiplied by 100%.
METHOD TWO
The second method arrives at the ROI by first subtracting the initial value of investment from the final value of investment. The result is then divided by cost of investment. After arriving at the result, it is converted to percentage by multiplying by 100%.
To accurately calculate ROI, total costs and total returns should be considered. Do not leave anything out. Below is a step-by-step breakdown of a typical ROI calculation.
Calculate net returns by considering total returns and total costs.
Calculate the gross capital by multiplying your net returns by the number of shares in that particular Investment.
Further dissect the ROI into component parts to get the capital gains and dividends. This is necessary because they are typically taxed differently.
In interpreting ROI calculations, there are three things you need to bear in mind.
ROI is expressed as a percentage, because this is relatively easier to understand, as opposed to ratio or multiples.
The ROI calculation makes use of the net returns in the numerator because an investment's returns could either be positive or negative.
When the results of the ROI calculation are in a positive figure, this implies that there net returns are in the black and the investment has produced a profit. But when investments yield a loss, the ROI calculations yield negative figures and the net returns are in the red.
The ROI is a simple metric that clearly shows you the return on an investment and its profitability. Despite its limitations, ROI is still used by business analysts and investors as a major investment metric in evaluating and valuing investment’s allocations.
Written by Lawretta Egba.